Isolating Incentives: Where Are the Carrots Aligned?

Incentives: There is much to be said about incentives and how they influence our individual and collective actions, for better or for worse. It was incentives that unfortunately helped cause the last recession, extravagantly compensating Moody’s credit analysts by quantity (piecework) of rated ABS, MBS and CDSs. Quality of work deteriorated and everything was quickly rated AAA even though it shouldn't have. Without the credit rating agencies' blessing, banks would not be able to sell the securities and pension funds unable to buy, suppressing a large portion of both demand and supply.

Real Estate Commission Example

A great example examining the influences of incentives is real estate agents. (There is provided below a quick three-minute video from "Freakonomics.") Essentially, the real estate agents are influenced by quantity or “closing time” as opposed to looking out for the house seller or buyer, achieving the highest or lowest closing price regardless of closing time.

We can also all think about the typical example of the stock broker who has an incentive to turn our portfolio for commission, inducing us to trade/gamble our hard-earned savings. Fund managers have an incentive to hug the index to keep their job, continually collecting fees from AUM. Established (wealthy, schloarly or political) people are more risk averse, as they have a position to protect and plenty of options. People in poverty or that are not established have fewer options and thus are induced to be risk seeking. The list is endless.

A great quote by Steven Levitt from "Freakonomics" holds true now more then ever while the global bankers (BOJ, BOC, PBOC, FED, ECB, BOE) are holding the golden carrot, artificially creating demand for the lower end of the yield curve, systematically suppressing interest rates. This pushes investors all over the world to reach further up the risk curve for an equivalent return they may have earned otherwise. Historical risk adjusted returns (theoretically) suffer.

“An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation.” – Steven Levitt

Warren Buffett (Trades, Portfolio) and Charlie Munger have been advocates of understanding incentives, the biases they cause and have talked numerous times about incentives over the years. Thinking about the incentives involved in a typical situation is a form of inverting the situation, examining it from the other parties’ point of view. Usually, identifying incentives is a great way to avoid a toxic situation or to partake in an enriching one.

So Why, As an Investor Could This Be Beneficial?

Well think about management’s ownership and how this may benefit you. We have all heard the phrase “aligned incentives” but what does it mean? It means that the parties involved are striving towards a similar incentive or goal with reciprocity as the targeted outcome. These are the situations (as investors and business owners) we want to be involved in.

But take the incentives of a management team facing fraud allegations (think Enron's Jeff Skilling), willing to fight until the bitter end. Not only is their job at stake, but personnel criminal charges are also a possibility.

Identifying where incentives are aligned can be difficult, but if or when a plausible scenario is identified where incentives are aligned in a positive manner, it is best to ride the wave, so to speak.

One personal example of my own that comes to mind is JPMorgan (JPM).

Jamie Dimon bought roughly $20 million worth of JPMorgan shares in the summer of 2012 after the London Whale loss. This instantly caught my attention because I knew it was a large loss (cut the stock 25%) and Dimon already owned a large portion of stock. With the $20 million purchase he was putting his money where his mouth was when he told the Street it was a one-off situation. From what I can recall from my research, he had a net worth of $200 million at the time, most in JPM common shares. The new purchase represented a 10% net worth bet on a horse that he would be jockeying.

The point is, I purchased 200 shares the next morning at $33 (it went to $30 or $31) doing absolutely no research other than on Jamie Dimon’s compensation and incentives, reading the 2011 annual report, and seeing JPMorgan was valued under B/V after a quick balance sheet examination. I sold the shares shortly after in the fall of 2012 for just shy of $40 or a 20% return in three months. The moral of the story: Ride the bigger fishes' currents, it is a lot less work.

Stock options that are awarded can also be influential incentives behind the company’s performance (or GAAP-reported performance). Stock option induced incentives can create short-term thinking and a desire to achieve analysts' estimates, sacrificing long-term shareholder value because the ones with the options have no skin in the game, hence one of the reasons Warren Buffett is not fond of (and does not issue) options but pays bonuses in cash on a pay-for-performance basis.

Executive Compensation

The following is an excerpt from Buffett (Trades, Portfolio) regarding executive compensation and identifying executive incentive structure, i.e. compensation.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all- too-prevalent rule is that nothing succeeds like failure.

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.”

(Let me pause for a brief confession: In criticizing comp committee behavior, I don’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .)

Avoid Excessive Top-Heavy Compensation Structures

As we can see, identifying outright ownership is an important variable to isolate as it directly aligns with our position, direct ownership through common shares. Stock options, hidden conflicts of interest (consulting fees, kicked to self owned subs or friends), salaries, bonuses and other “perks” can be examined with a search on the Internet and proxy statements (specifically DEF 14A).

If we find incentives are not aligned and compensation is abused at the expense of shareholders, it is time to flip the next rock and move on. If we find incentives are aligned it is time to dig deeper or buy a stake in the business. For the rest of 2014 and beyond let us all practice identifying incentives and inverting situations we face whether investing related or personal, proverbially standing in the shoes of others.

"I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. Never a year passes that I don't get some surprise that pushes my limit a little farther." – Charlie Munger

About the author:

Tannor Pilatzke

I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

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